Gundlach: The Two Questions that Matter Most
A huge underclass of the “seemingly permanently unemployed” was one cause of the decline of the Roman Empire, Gundlach said. He said that similar conditions plague the US today. The employment-to-population ratio has decreased from 65% to 59% since 2008 – despite what Gundlach called a “kitchen sink” of stimulus measures. He said that he doesn’t expect that ratio to improve, at least not under the budget that Obama has just proposed.
Don’t be misled by the modest improvement in the unemployment rate, Gundlach cautioned. It is only because the “denominator is shrinking” – the size of the workforce is contracting. Finding employment is particularly challenging for younger Americans; the labor participation rate for 16- to 19-year olds has gone from 60% to 30% since the financial crisis.
Another indicator of the growing size of the underclass, according to Gundlach, has been the increase in the number of Americans on food stamps – now approximately 46 million of our 313 million people.
Gundlach noted some trends in the unionization of the workforce, although on this point he did not draw any parallels to the Roman Empire. Within the private sector, he said, most industries are becoming less unionized – for example, wholesale and retail trade and even manufacturing. But federal, state and local government workers are now “massively unionized,” he said.
“No wonder we are in a situation where it's difficult to get the fat out of the government, when there is all this kind of unionization happening,” he said. “It has led to an outsized comparison of private- versus public-sector earning power.” In 2000, he noted, federal civilian workers made $76,000 annually, versus $46,000 in the private sector, including benefits. As stunning as that difference was then, the gap has widened; federal workers now make $120,000, versus $60,000 in the private sector.
“Something about this clearly is responsible for part of the massive deficit problem that we continue to deal with – and will continue to deal with, certainly throughout the course of this year and next year,” he said.
Two key questions
The Roman Empire declined slowly over a period of several hundred years, Gundlach said. Advances in technology and information flow suggest that the US might have much less time to address its debt problems, he said, adding that the answers to the two key questions described above should guide investor decisions in the short term.
On the question of what will happen when government stimulus ends, one insight comes from the data for real personal disposable income in the US, Gundlach said. The official data shows that income rose dramatically until 2008, then fell steeply during the recession before rebounding over the last couple of years. But, according to Gundlach, a more telling story emerges from the data after it is adjusted by eliminating transfer payments, such as extended unemployment benefits and food stamps. It shows that the recent rebound is a mirage – income is at the same level as in 2005 – and growth has been entirely stimulus-induced.
“When the stimulus ends you are going to see negative movement in economic growth,” Gundlach said.
The second question is when the Fed will increase interest rates. The Fed’s most recent announcement was that the Fed funds rate will be maintained at near-zero levels until late 2014. Its previous policy announcement was to keep rates at that level only until mid-2013.
But under Bernanke the Fed has adopted more a transparent communication policy, and the Fed’s meeting minutes showed that 11 of the 17 Fed Governors favored raising interest rates sooner than late 2014 – possible as early as this year.
“While the message from the Fed is rates will be low for another three years or so,” he said “a lot of the voters in the survey don't even believe their own chairman. We need to be open-minded about where interest rates are going, but certainly in the short term it seems extraordinarily unlikely to me that short-term interest rates are about to be raised.”
Gundlach’s uncertainty with respect to the Fed’s direction on interest rates was reflected in his forecast for the fixed-income markets, where he expects rates to remain largely unchanged, at least in the near term.
Overall, he said that Treasury yields are “carving out a bottom,” but that is a process that may take “years” to complete.
The two-year note, he said, doesn’t seem to be able to hold its near-zero rates. Five-year yields have been “more muted” in their upward movements this year. Ten-year bonds have been “bottoming out,” he said, as have 30-year bonds, which are unlikely to go below 2.5%. But he warned against any significant changes in allocations. “I've been at this game a long time,” he said. “Usually when interest rate bottoms are put in, they are put in and there is a quick reversal out of them.”
The stock market, he said, is “very over-bought” with declining volume and the beginning of some very significant insider selling. “The market is vulnerable to a significant setback,” he said, but not one that would constitute a bear market in equities or “risk assets.” He said recent better-than-expected data on the economy were numbing investors into complacency, and “sowing the seeds for disappointment” for equity investors.
“This is a bad time to be deploying money in risk assets,” he said. “If you have a dollar-cost-averaging program, you certainly should turn it off for the time being.”
In response to a question Gundlach is often asked, he said inflation should not be an imminent concern. “We shouldn’t expect anything of great significance in the very near term.” The TIPS market confirms his prediction; it has been forecasting inflation of 2% to 2.25% for the past five years, he said.
Gundlach affirmed his earlier advice for investors to hold entirely dollar-denominated positions. He said that trouble in Europe will lead to a dollar rally, and that emerging markets will be vulnerable. A crisis in Europe, he said, would lead to a “repatriation of money back into Europe by European investors,” which would, in turn, trigger divesting of emerging-market positions.
Even dollar-based investors should heed a warning from the Roman Empire, though. In that era, the edges of coins were flat, and the Romans cleverly found that they could file small amounts of gold or silver from the sides of coins, in what was perhaps the earliest form of currency debasement.
The Romans solved their problem by adding small ridges to the edges of coins, a practice that continues today. Now investors should fear the modern-day form of debasement, Gundlach said. Our money may now trade as electronic computer blips, but its value still ultimately depends on the ability of our government to address its fiscal problems.